Selasa, 17 April 2012

Understanding the risks of Fed policy

Here's an updated version of a chart that I've followed for decades. What it tells me is that the Fed is in the process of repeating past errors, since they almost always react to developments in the economy rather than being proactive. In short, the Fed is way too easy today, and this portends higher inflation in the future.

Capacity utilization (blue line) is arguably a good proxy for the strength of the economy. The stronger the economy, the higher the utilization rate of factor capacity. (It's a flawed measure, I'll be quick to admit, since there is no way the Fed can actually measure the factory utilization rate—they have to make all sorts of assumptions and estimates to arrive at this number. But nevertheless it does seem to track the business cycle reasonably well.) Whatever the Fed might say about what guides monetary policy, the evidence suggests that the strength of the economy is an extremely important input.

The real Federal funds rate (red line) is arguably the best measure of how "easy" or "tight" monetary policy is. High real rates tend to increase the demand for money and slow the growth of the money supply, and if the Fed tightens enough, a relative scarcity of money develops which usually precipitates a recession. At the same time, the scarcity of money tends to pull down inflation. That's why inflation usually falls during and after recessions. As the business cycle matures, inflation tends to pick up because the Fed is slow to react to changes in the economy (note how the red line almost always lags the blue line).

What the chart is telling us now is that there has been a significant improvement in the health of the economy (the rebound in capacity utilization in recent years is unprecedented) but the Fed's monetary policy stance continues to be about as "easy" as it has ever been. Rarely has the Fed failed to respond for so long to a significant improvement in the economy. This suggests that the Fed is "falling behind the curve." We saw a similar situation in the late 1970s, when capacity utilization surged but it took the Fed several years before it got the nerve to push the real Fed funds rate above zero. One result of this delayed reaction, we now know, was that inflation accelerated significantly, rising from 5% in 1976 to a high of almost 15% in 1980. There are other troubling similarities between then and now: the dollar was very weak in the mid-1970s, commodity and gold prices were soaring, and Treasury yields were generally lower than the rate of inflation (i.e., real yields were negative across the yield curve).

I would also note that there were a few times in the past several decades when monetary policy became exceptionally "tight:" in the early 1980s, the Fed pushed the funds rate well above the rate of inflation, and they did the same in the late 1990s. Both periods were characterized by a subsequent and substantial decline in inflation.

To summarize: Monetary policy is very powerful, but it works with a lag that can amount to several years or more. (I should know, since I have been making this same forecast for the past three years. In my defense, I note that inflation today is much higher than it was expected to be three years ago.) The Fed is fallible, and usually reacts to events rather than being proactive. The Fed once again appears to be making a mistake by keeping interest rates very low for too long, even though the economy is improving noticeably, the dollar is very weak, and commodity prices are generally quite strong. As a consequence, inflation in the years to come is likely to be higher than the market expects (current inflation expectations embedded in TIPS and Treasury prices are 2-2.5%), than to be lower.

I've argued for a long time that it is too late for investors to seek inflation protection in gold. I think gold at current prices has already anticipated the likely consequences of the Fed's overly-easy monetary policy stance, and I think gold also reflects a substantial premium that investors seem willing to pay for protection against geo-political risk (e.g., the Eurozone sovereign debt crisis, which might destroy the euro, and the ongoing turmoil in the Middle East). Moreover, I think gold would react very negatively to even a hint that the Fed is going to accelerate its plans to raise interest rates.

I think it makes more sense to seek inflation protection in real assets that are still relatively depressed, and real estate jumps out as arguably the ideal candidate. I also believe that equities represent decent inflation hedges, since PE ratios are generally low and corporate profits over time inevitably benefit from increases in nominal GDP. (If inflation picks up, this is good for everyone's cash flows.)

Cash is hardly a safe haven these days, since it currently offers no yield, whereas the earnings yield on equities and the yields on corporate bonds provide substantial cushions against downside risk. And of course, if inflation proves to be higher than expected, then the purchasing power of cash will deteriorate significantly. Cash could prove to be the world's worst investment in the years to come.

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